Disinflation in non-Eurozone EU nations

Plamen Iossifov, Jiří Podpiera 16 February 2015



Inflation has been falling sharply across Europe since 2012 (Figure 1). Across Central and Eastern Europe (CEE), inflation expectations have also drifted down, especially among countries who peg their currencies to the euro (Bulgaria, Croatia, as well as Lithuania, which has since adopted the euro on 1 January 2015), but also in those that target their inflation rates (Czech Republic, Hungary, Poland, and Romania).

Figure 1. Headline inflation (12-month growth rate in %)

Source: Eurostat.

Note: Data for non-Eurozone countries are weighted averages of harmonised consumer price indices, using country HICP weights for 2013.

Figure 2. Consensus forecasts of inflation two years ahead, 2004–2014 (%)

Source: Consensus Economic Long-Term Forecasts.

Note: In a given quarter, the plotted observation is the mean forecast of average annual inflation two years ahead (e.g. in December 2013 the forecast for 2015 is plotted, and in March 2014 that for 2016).

The recent drop in world oil prices has re-ignited the debate about good versus bad disinflation. For the Eurozone, risks from low inflation have been discussed in Moghadam et al. (2014). This column examines the causes and potential consequences of falling inflation from the perspective of EU countries outside the Eurozone.

Disinflationary dynamics

Falling world food and energy prices, and where relevant cuts in administered prices of energy, have been an important driver of disinflation across EU countries outside the Eurozone.

Figure 3. Contributions to headline inflation, 2012–2014 (percentage points contributions to 12-month growth rates of HICP)

Sources: Eurostat and IMF staff estimates.

Furthermore, core inflation – overall inflation excluding volatile food and energy prices – has also drifted down, tracing price trends in the Eurozone, and increasingly diverging from developments in the rest of the world (Figure 4). This suggests possible disinflationary spillovers from the Eurozone to other EU countries, in light of their close trade links.

Figure 4. Core inflation (12-month growth rate in %)

Source: Haver, Eurostat, and IMF staff calculations.

Notes: Data for non-Eurozone EU countries are weighted averages, using country HICP weights for 2013. Data for the world excluding EU countries are weighted averages, using country GDP weights.

Our recent IMF Working Paper (Iossifov and Podpiera 2014) confirms the dominant role of these two factors. Decomposition of inflation variance based on an estimated open economy, New Keynesian Phillips curve for the region suggests that:

  • Falling world food and energy prices and related cuts in administered prices accounted for the largest share of the inflation decline in non-Eurozone EU countries in CEE.
  • Disinflation spillovers from the Eurozone have been an important factor for euro peggers, and to a smaller extent for inflation targeters. Falling Eurozone core inflation transmits through lower prices of imports to countries with currencies pegged to the euro, and to inflation targeters with higher foreign value-added content in domestic demand.
  • In contrast, the domestic economic cycle – measured by the unemployment gap – has had a marginal impact in the recent disinflationary episode. In addition, the nominal effective exchange rate has been proportionately more important in inflation targeting countries.

Figure 5. Headline inflation variance decomposition, 2012:Q1–2014:Q1 (contributions in %)

Source: IMF staff calculations.

Note: Inflation variances are normalised to the variance of CEE euro peggers. Based on full-sample regression coefficients. Eurozone core inflation includes effects of administered prices and taxes.

What it means for the economy

With rapidly falling world oil prices, disinflation pressures are unlikely to abate any time soon. According to the latest World Economic Outlook forecasts (IMF 2015) and our estimates, headline inflation is expected to stay low through 2015 in euro peggers and remain below targets in Hungary, Poland, and Sweden.

In fact, the sharp decline in oil prices since June 2014 will drag inflation lower, as the commodity price drop filters through to domestic prices. Is this good or bad for the economy? A 2009 Vox column by Robert Ophèleon the Eurozone’s previous disinflationary episode in the wake of the Global Crisis remains a reliable guide in thinking through this issue.

The prospect of lower cost-of-living and production costs is undoubtedly a positive development in the short run:

  • Lower energy prices boost the purchasing power of households and businesses. Given the still negative output gaps throughout the region, a pick-up in demand would be a boon for domestic producers.
  • The lower consumer and firm outlays on goods and services would also ease the liquidity strains of debt service for heavily indebted firms and households, reducing the risk of default and the related negative effect on consumption and investment.

But, low inflation/deflation increases debt sustainability risks and raises the possibility of ‘second-round’ disinflationary effects in the medium term that have proven difficult to reverse:

  • The prospect of falling prices could suppress domestic demand, if it prompts households and firms to revise down expectations for wages and profits and thus to cut consumption and investment. These ‘second-round’ disinflationary effects can trigger a self-feeding, vicious feedback loop between inflationary expectations and prices – a deflationary trap.
  • Persistent disinflation and particularly deflation can complicate the process of deleveraging by heavily indebted firms and households, as it increases the real debt burden. This can be further exacerbated by stagnating nominal incomes, to the extent that the loss of income is not offset by the pass-through of lower inflation via nominal interest rates to debt servicing costs.

Policymakers’ predicament

Overall, the fall in oil prices will likely boost growth in the short run. But, it poses challenges to monetary policymaking, which focuses on medium-term risks. A prolonged undershooting of the inflation objective could damage central banks’ credibility, which would make it much harder to escape the deflation trap. What should policymakers do?

Countries that peg to the euro do not have independent monetary policies and would have to rely on the ECB’s quantitative easing policy response to persistently low inflation in the Eurozone (ECB 2015). Where fiscal space allows, countries could also use discretionary, expansionary fiscal policies.

Inflation-targeting central banks strive to keep inflation close to target over the medium-term. Consequently, when faced with renewed disinflationary pressures, they should aim at bringing inflation closer to its target, by stamping out ‘second-round’ disinflationary effects of falling energy prices.

However, this could be challenging. With policy instruments at historical lows or at the zero lower bound, further easing by inflation-targeting central banks would need to weigh the benefits of normalising price pressures with potential concerns about the impact on financial stability and capital flows and hence exchange rates. Easing monetary policy too much may prompt capital outflows, and while this may help depreciate exchange rates and raise inflation, there is always a risk that the process may go too far. This is of particular concern for countries with a high share of debt in foreign currencies, which are more exposed to changes in investors’ risk appetite, geopolitical concerns, and global financing conditions.

On balance, the greater concern at present appears to be very low inflation and the possibility of sliding into a deflationary trap than financial instability on account of capital outflows, but policymakers will need to keep a watchful eye on markets.


ECB (2015), Press conference, Frankfurt, 22 January.

IMF (2015), World Economic Outlook Update, January 2015.

Iossifov, P and J Podpiera (2014), “Are Non-Euro Area EU Countries Importing Low Inflation from the Euro Area?”, IMF Working Paper 14/191.

Moghadam, R, R Teja, and P Berkmen (2014), “Euro Area Deflation versus Lowflation”, iMFdirect blog, 4 March.

Ophèle, R (2009), “Deflation or disinflation?”, VoxEU.org, 11 February.



Topics:  Europe's nations and regions Exchange rates Monetary policy

Tags:  monetary policy, disinflation, Europe, eurozone, food prices, energy prices, exchange rates, Commodity prices, spillovers

Senior Economist in the European Department, IMF

Economist in the European Department, IMF


CEPR Policy Research